SEP IRA versus Solo 401(k)-Which is Better?

Your Investing Questions Answered

When I first offered to respond to their investing questions, I expected a few simple queries that I could answer in a paragraph or two.

I was wrong!

The investing questions keep coming in and they are complicated.

Due to the vast number of questions, Thursday’s will be investing question and answer day.

SEP IRA versus Solo 401(k)

A big shout out to one of my favorite personal finance bloggers, Robert of The College Investor who jumped in with this question:

“What’s the best option for the self-employed – a SEP IRA or a Solo 401k? What are the pros and cons of each? Does the amount of income you make matter for your choice?” Robert of The College Investor

What is the Difference Between a SEP-IRA and Solo 401(k)?

Fortunately, I just did a comprehensive article on the ins and outs of a SEP -IRA. As a quick refresher, A SEP IRA is similar to an individual traditional IRA yet allows much larger contributions for the self employed, freelancer, or solopreneur. This type of retirement plan allows the employer (even one without employees) to contribute up to 25 percent of an employee’s salary (capped at $51,000 in 2013) into this retirement vehicle.

A SEP IRA allows an employer to contribute up to 25 percent (with a maximum contribution of $51,000 in 2013) of each eligible employee’s salary into a specially set up Traditional IRA for that employees future. The contributions are allowable even if you are the employer and employee! Since the SEP IRA is discretionary, the employer can choose to contribute one year without the obligation to contribute the next.

The solo 401(k) is set up for someone running their own business or one with an immediate family member. The contribution limits for this type of retirement plan are the same as those for a company sponsored 401(k) but the sole proprietor can make an additional contribution as well. The small business owner acts as employer and employee when funding a solo 401(k). She can contribute as the “employee” and the “employer” to an independent 401(k), thus increasing the total contribution limit.

In 2014, an individual can contribute up to $17,500 to a solo 401(k) and those over 50 can allocate an additional $5,500. The employer part of the contribution can add up to an additional 25 percent of compensation. The maximum annual contribution is capped at $$51,000 (not including catch up contributions) for 2013 and $52,000 for 2014. If you make $200,000 per year and are older than 50, you can contribute $51,000 plus $5,500 catch up contributions for a total of $56,500 to your solo 401(k).

Continuing with the same example, the entrepreneur making $200,000 with a SEP IRA can contribute a maximum of $51,000 with no catch up contribution. This calculation is a bit tricky because you need to take into account a deduction for self-employment tax. Then there’s a contribution rate formula that is used. According to Vanguard’s plan contribution calculator, the SEP IRA allows for a $38,054.49 contribution.

Pro’s and Con’s of a SEP IRA

Pro: Easy to set up and minimal administrative responsibilities.

Pro: High contribution limit; $51,000 for 2013.

Pro: SEP IRA can be converted to a solo 401(k) if desired.

Con: No additional $5,500 catch up provision for those age 50 and older. Solo 401(k) may allow greater contribution for older high earners.

Con: IRS does not allow loans from a SEP IRA.

Pro’s and Cons’s of a Solo 401(k)

Pro: High contribution limit; $51,000 for 2013 plus $5,500 catch up contribution for those over 50. Calculation method usually allows for higher contributions than the SEP IRA.

Pro: Able to borrow (tax free) from solo 401(k) if necessary.

Con: Greater administrative responsibilities and costs than for SEP IRA.

The Answers

What’s the best option for the self-employed – a SEP IRA or a Solo 401k? It depends. If you don’t foresee needing to borrow from your retirement account and aren’t earning enough to be concerned with the lower contribution limit of the SEP-IRA then this is probably the simplest retirement savings vehicle for you.

If you like the option of being able to borrow from and make larger contributions to the plan, then the solo 401(k) may be a better choice. Just be ready for more paperwork.

Does the amount of income you make matter for your choice? Yes, in most cases, the solo 401(k) allows for higher retirement plan contributions.

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I am a portfolio manager, former university finance instructor, and successful investor committed to sharing my personal finance expertise with you. I am not a licensed financial advisor. Please do not construe the suggestions on this website as recommendations for your personal situation. For any individual financial advice please seek your own licensed and/or registered personal financial adviser or CPA. Per FTC guidelines, this website may be compensated by companies mentioned through advertising, affiliate programs or otherwise.